International taxation of cross-border leasing income - CHAPTER 5 LIMITS OF TAX-DRIVEN CROSS-BORDER LEASING TRANSACTIONS

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International taxation of cross-border leasing income

Mehta, A.S.

Publication date

2004

Link to publication

Citation for published version (APA):

Mehta, A. S. (2004). International taxation of cross-border leasing income.

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CHAPTERS S

LIMITSS OF TAX-DRIVEN CROSS-BORDER

LEASINGG TRANSACTIONS

5.1.. Introduction

Overr the past few decades, taxpayers have engaged in tax-driven leasing transactionss for maximizing tax advantages. The tax advantages sought to bee derived from the leasing transactions could be in the form of enhance-mentt of deductions (for instance, depreciation, interest deduction, etc.) or defermentt of taxable leasing income, or a combination of enhancement of deductionss as well as deferral of income.

Inn their pursuit of maximizing tax advantages, particularly with respect to big-tickett assets, taxpayers often prefer aggressive leasing transactions. Analyticall review of the various transaction structures suggests the possi-bilityy of grouping the tax-driven leasing transaction structures as structures designedd to:

-- exploit the transaction characterization rules of the national tax laws (e.g.. sale-and-leaseback, double-dip transactions, etc.);

-- facilitate the deferral of taxation of leasing income (e .g. leases with bal-loonn rental payments);

-- circumvent the restrictive or anti-avoidance provisions of a tax law (e.g.. chain-lease, replacement lease and lease-in-lease-out transac-tions); ;

-- facilitate the transfer of tax advantages to equity investors in the lessor entityy (e.g. organizing the lessor entity in the form of transparent enti-ties); ;

-- avail of certain beneficial provisions of tax laws or tax treaties (e.g. structuress to benefit from the tax sparing credit provisions in tax trea-ties);; and

-- enhance tax advantages by increasing a lessor's capacity to lease (e.g. leveragedd leases with non-recourse financing, defeasance structures, etc.). .

Thee tax laws of many jurisdictions have specific restrictive or anti-avoid-ancee provisions to impede aggressive leasing transactions. However, due to thee dynamic characteristic of the financial services industry, the players in

thee leasing arena have been able to innovate the transaction structures be-yondd the clutches of such restrictive or anti-avoidance provisions, that are inevitablyy followed by consequential amendments in the national tax laws too plug loopholes. However, the plugging of the said loopholes is often foundd not pre-emptive enough to check further innovation of the leasing transactionn structures. In such cases the only remedy available to the tax au-thoritiess is to invoke the general anti-avoidance rules, though they may not alwayss prove effective.

Thiss chapter aims to explore the current limits of the tax-driven leasing transactionss by analysing:

(i)) the relevant general anti-avoidance principles in the select jurisdic-tions; ;

(ii)) the types of tax-driven leasing transaction structures commonly under-takenn by taxpayers; and

(iii)) specific provisions under the national tax laws or court decisions that mayy have influence on such transaction structures.

5.2.. Relevant anti-avoidance rules in select jurisdictions:

aa brief overview

5.2.1.. United States

Thee IRC does not specifically include a general anti-avoidance rule.169 However,, the United States being a common law jurisdiction, substantial taxx jurisprudence on the subject of tax avoidance has developed as a result off court decisions.170 The general anti-avoidance principles in the United Statess may be classified into the following doctrines:

(a)) the sham transaction doctrine; (b)) the step transaction doctrine; (c)) the business purpose doctrine; (d)) the substance-over-form doctrine; and

(e)) the economic substance doctrine or the economic sham transaction doctrine. .

169.. See Streng, Yoder, "Form and Substance in Tax Law" (Chapter for the United States,, paragraph 5.4), Cahiers de droit fiscal international, Volume LXXXVIIa, IFA 20022 Congress, Oslo.

170.. See Streng, Yoder, "Form and Substance in Tax Law" (Chapter for the United States,, paragraph 5.3), Cahiers de droit fiscal international, Volume LXXXVIIa, IFA 20022 Congress, Oslo.

Relevantt anti-avoidance rules in select Jurisdictions: a brief overview

Itt is important to note that these doctrines are not mutually exclusive, and thee IRS may seek to neutralize an aggressive transaction by invoking more thann one doctrine.

5.2.1.1.. The sham transaction doctrine

AA sham transaction could be either a "factual sham" transaction or an "eco-nomicc sham" transaction. A transaction is regarded as factual sham, when thee factual events occurring in the course of a transaction are inconsistent withh the transaction described by the taxpayer in the relevant documents. In otherr words, a transaction is regarded as a factual sham if it is found to be "fake". .

Thiss doctrine covers only the factual sham transactions, and the economic shamm transactions are covered under the economic substance doctrine.171 In casess where the sham transaction doctrine applies, the relevant transaction documentss are disregarded and the transaction is considered non-existent forr tax purposes.172

5.2.1.2.. The step transaction doctrine

Underr the step transaction doctrine, separate transactions within a series of transactionss are treated as one composite transaction, if such a treatment moree accurately reflects the underlying substance of the transactions. In thiss regard, the US Supreme Court decision in Minnesota Tea Co. v. HelveringHelveringmm is considered an authority.

Itt appears that for ascertaining whether the step transaction doctrine applies too a particular series of transactions, the US courts have applied three main tests,, namely:174

177 i. For that reason, the economic substance doctrine is also referred to as "economic shamm transaction doctrine".

172.. For a detailed discussion on this doctrine, see Streng, Yoder, "Form and Substance inn Tax Law" (Chapter for the United States, paragraph 5.7.4), Cahiers de droit fiscal

in-ternational,ternational, Volume LXXXVÜa, IFA 2002 Congress, Oslo.

173.3022 US 609 (1938). In this decision, the Supreme Court coined the step transaction doctrinee by stating that a given result at the end of a straight path does not change by tak-ingg a devious path.

174.. See Country Report for the United States by William P. Streng and Lowell D. Yo-der,, "Form and substance in tax law", Cahiers for the 2002 IFA Congress.

(i)) the binding commitment test; (ii)) the mutual interdependence test; and (iii)) the end result test.

AA series of transactions can be combined as one composite transaction un-derr the binding commitment test if, at the time of the first transaction the taxpayerr was under a binding obligation to follow the other transactions. Conversely,, in absence of such binding obligation on the taxpayer, a series off transactions cannot be combined as one composite transaction unless the otherr two tests under this doctrine apply.175

Underr the mutual interdependence test, a series of transactions can be clubbedd together as one composite transactions if the relationship between thee two or more transactions is such that the legal relationship arising from onee transaction would have been meaningless without undertaking the otherr transactions within the series.176

Underr the end result test, a series of transactions can be combined as one transactionn if so intended by the parties to the transactions. Apparently, this thirdd test resembles the "substance-over-form doctrine".177

5.2.1.3.. Business purpose doctrine

Underr the business purpose doctrine, a transaction or a series of transac-tionss is disregarded if the transaction lacks a valid business purpose other thann avoidance of federal tax. Gregory v. Helveringm is the leading author-ityy on this doctrine, wherein the US Supreme Court disregarded a corporate

175.. The US Supreme Court decision in Commissioner v. Gordon 391 US 83 (1968). In thiss case, a corporation distributed 57% of the stock of its wholly owned subsidiary to its shareholderss and informed the shareholders that it intended to distribute the remaining 43%% stock within the next few years. Two years subsequent to the first distribution, when thee corporation distributed the remaining 43% stock, the taxpayer claimed that the two distributionss should be combined as one transaction so as to treat it as a tax-free reorgan-ization.. Rejecting the claim of the taxpayer, the Court held that for a transaction to be characterizedd as first step in a composite transaction there must exist a binding commit-mentt in respect of the later step.

176.. American Bantam Car Co v. Commissioner 11 T.C. 397 (1948), affd per curium, 1777 F.2d 513 (3rd Or. 1949), cert, denied 339 US 920 (1950).

177.. For a discussion on step transaction doctrine, see Streng, Yoder, "Form and Sub-stancee in Tax Law (Chapter for the United States, paragraph 5.7.1), Cahiers de droit

fis-calcal international, Volume LXXXVIIa, IFA 2002 Congress, Oslo.

Relevantt anti-avoidance rules in select jurisdictions: a brief overview

reorganizationreorganization for want of an underlying business purpose. The following extractt from the decision forms the genesis of the doctrine:

Whenn [the statute] speaks of a transfer of assets by one corporation to another, itt means a transfer made "in pursuance of a plan of reorganization" of corporate business;; and not a transfer of assets by one corporation to another in pursuance off a plan having no relation to the business of either, as plainly is the case here .... [T]he transaction upon its fact lies outside the plain intent of the statute. To holdd otherwise would be to exalt artifice above reality and to deprive the stat-utoryy provision in question of all serious purpose.179

5.2.1.4.. The substance-over-form doctrine

Underr the substance-over-form doctrine, the tax authorities or a court may recharacterizee a transaction in accordance with its economic substance, if thee legal form of the transaction does not reflect its true economic sub-stance.180 0

Inn Gregory v. Helvering,m the US Supreme Court disregarded the legal formm (corporate reorganization) and held that, in substance, the transaction wass in respect of dividends of appreciated securities taxable as ordinary in-comee of the taxpayer.182

5.2.1.5.. The economic substance or the economic sham transaction doctrine e

Underr this doctrine, a taxpayer is denied a tax advantage if the economic substancee of the transaction is insignificant compared to the tax

advan-179.. For a discussion on business purpose doctrine, see Streng, Yoder, "Form and Sub-stancee in Tax Law" (Chapter for the United States, paragraph 5.7.2), Cahiers de droit

fis-calcal international, Volume LXXXVIIa, IFA 2002 Congress, Oslo.

180.. For a discussion on substance over form doctrine, see Streng, Yoder, "Form and Substancee in Tax Law" (Chapter for the United States, paragraph 5.7.3), Cahiers de droit

fiscalfiscal international, Volume LXXXVIIa, IFA 2002 Congress, Oslo.

181.2933 US 465 (1935).

182.. ASA Investerings Partnership v. Commissioner (T.C. Memo 1998-305, affd. 201 F.3dd 505 (2000), cert, denied, 531 US 87) is a recent case where the Court applied the substance-over-formm doctrine to recharacterize a transaction.

tage.. Goldstein v. Commissioner1*4 is one of the early cases where atrans-actionn was disregarded due to lack of economic substance.

ACMACM Partnership v. Commissioner1_*5 _{is another leading case where a}

trans-actionn (purchase and sale of a property within a 24-day period) was disre-gardedd for want of economic substance. However, in United Parcel Service v.. Commissioner1*6 the Court of Appeals (11th Circuit) respected a transac-tionn as the taxpayer was able to demonstrate economic substance in the transactionn challenged by the IRS.

Ass various federal courts of appeal in the United States are organized in dif-ferentt circuits, the decisions of one federal court of appeal are not binding onn the other federal courts of appeal. Accordingly, it is possible that two federall courts of appeal may reach contrasting conclusions on the same is-sue.. This aspect could be best appreciated by comparing the outcome of comparablee dividend-stripping transactions in Compaq Computer Corp. v.

CommissionerCommissioner11**77 and IES Industries Inc. v. United States.1**

Inn Compaq Computer Corp. v. Commissioner, the taxpayer acquired "cum dividend"" certain American Depository Receipts (ADRs) issued by Royal 183.. For a discussion on this doctrine, see Streng, Yoder, "Form and Substance in Tax Law"" (Chapter for the United States, paragraph 5.7.4), Cahiers de droit fiscal

interna-tional,tional, Volume LXXXVIIa, IFA 2002 Congress, Oslo.

184.. 364 F.2d 734 (2nd Cir. 1966). In this case, the taxpayer sought to derive a tax de-ferrall benefit by taking a loan involving prepaid interest to invest in US Treasury secur-itiess that did not involve prepaid interest. As the transaction lacked economic substance andd the only underlying purpose was to obtain a significant amount of tax deduction (to sett off against sweepstakes winnings by the taxpayer), the Court disregarded the trans-action. .

185.. T.C. Memo 1997-115, aff d. in part and reversed in part, 157 F.3d 231 (3rd Cir. 1998),, Cert, denied 526 US 1017 (1999). In this case, the Court of Appeals remarked aboutt the transaction that "viewed according to their objective economic effect rather thann their form, transactions involved only a fleeting and economically inconsequential investmentt in and offsetting divestment from the [debt instruments] ... The transactions withh respect to the [debt instruments] left the [taxpayer] in the same position it had oc-cupiedd before engaging in the offsetting acquisition and disposition of Üiose notes." 186.2544 F.3d 1014 (11th Cir. 2001). In this case, the package delivery service company Unitedd Parcel Services (UPS) formed a subsidiary in Bermuda which assumed (for com-pensation)) certain UPS risks for lost or damaged parcels. The IRS sought to disregard the transactionn between UPS and the Bermuda subsidiary and tax profits of the Bermuda subsidiaryy as income of UPS. UPS was successful in arguing before the Court of Appeals thatt its transaction with the Bermuda subsidiary had economic substance and it com-prisedd a genuine exchange of obligations between two real and independent entities. On thatt ground, the Court of Appeals respected the transaction.

187.. 277 F.3d 778 (5th Cir. 2001). 188.2533 F3d 350 (8th Cir. 2001).

Relevantt anti-avoidance rules in select jurisdictions: a brief overview

Dutchh Petroleum and sold the same "ex dividend" within an hour of the ac-quisition.. Though the transaction could not be expected to yield any eco-nomicc benefit, the taxpayer sought to acquire foreign tax credits to the extentt of USD 3.4 million and set off the capital loss189 (for tax purposes) producedd by the transaction against another taxable capital gain. The Tax Courtt disregarded the transaction due to lack of economic substance. On furtherr appeal by the taxpayer, the Court of Appeals (5th Circuit) comment-edd that the transaction did not involve a bona fide business purpose and the Courtt was not persuaded that Congress intended to encourage or permit a transactionn that merely manipulated the foreign tax credit system to achieve USS tax savings.

IESIES Industries Inc. v. United States involved a similar dividend stripping

transaction.. However, unlike in Compaq Case, the Court of Appeals (8th Circuit)) respected the transaction.

5.2.1.6.. The US Supreme Court decision in the Frank Lyon case InIn the context of respectability of the legal form of a lease transaction, the followingg observations made by the US Supreme Court reflect the relevant principle:190 0

Wheree there is a genuine multiple-patty transaction with economic substance whichh is compelled or encouraged by business or regulatory realities, is im-buedd with independent considerations, and is not shaped solely by tax-avoidancee features that have meaningless labels attached, the Government shouldd honor the allocation of rights and duties effectuated by the parties. Ex-pressedd another way, so long as the lessor retains significant and genuine at-tributess of the traditional lessor status, the form of the transaction adopted by thee parties governs for tax purposes. What those attributes are in any particular casee will necessarily depend upon its facts. It suffices to say that a sale-and-leaseback,, in and of itself, does not necessarily operate to deny a taxpayer's claimm for deductions.

189.. As the ADRs were sold "ex dividend", the taxpayer fetched a lower price as com-paredd to the price it had paid for purchasing the ADRs "cum dividend". This difference resultedd in a capital loss for tax purposes, though, in reality, the taxpayer did not incur anyy loss as the "capital loss" represented the dividend value in the ADRs which the tax-payerr encashed before selling the ADRs.

5.2.1.7.. Application of "two-fold test" by the lower courts in the Unitedd States

InIn recent cases, as discussed hereafter, the lower courts have applied the followingg two tests to determine whether a transaction should be respected ass a lease for federal income tax purposes:

(i)) whether the transaction is not a sham devoid of economic substance ("shamm transaction test"); and

(ii)) whether the lessor has acquired and retained the requisite burdens and benefitss of ownership of the leased property ("burden and benefits of ownershipp test").

Wheree both the tests show a positive result, generally the courts have re-spectedd the transactions as a lease.

(i)) Sham transaction test

Thee "sham transaction test" consists of a factual analysis.191 In recent cases, thee courts have focused on the economic substance of the transactions.192 Thee economic substance analysis consists of an examination of the object-ivee factors indicating whether the taxpayer had a reasonable opportunity to receivee economic profit from the transaction, apart from any tax benefit. Inn one case,193 the Tax Court considered the following factors as significant inn analysing whether a transaction has economic substance apart from tax benefits: :

-- presence (or absence) of arm's length price negotiations; -- relationship between the sale price and the fair market value; -- financial structure of the transaction;

-- degree of adherence to contractual terms; and

-- reasonableness of the income and residual value projections.

191.. SeeSmootv.Commissioner,61 T.C.M.(CCH)2897 (1991);Emershaw

v.Commis-sioner,sioner, 59 T.C.M. (CCH) 621 (1990), aff d, 917 F.2d 1040 (8th Cir. 1990).

192.. See Shriver v. Commissioner, 899 F.2d 905 (10th Cir. 1990); Casebeer v.

Commis-sioner,sioner, 862 F.2d 1486 (11th Cir. 1989); Rose v. Commissioner, 868 F.2d 851, 854 (6th

Cir.. 1989).

Relevantt anti-avoidance rules in select Jurisdictions: a brief overview

(ii)) Burden and benefits of ownership test

Generally,, for a lease transaction to be respected, the lessor must have the "upside"" (profit and appreciation benefits) and "downside" (risk of loss) withh respect to the property.194

5.2.2.. United Kingdom

InIn the United Kingdom, tax consequences are determined by the legal form off a transaction, unless such result would conflict with the general or spe-cificc anti-avoidance rules (the general anti-avoidance principles are de-velopedd by the judge-made common law).195 As specific anti-avoidance provisionss may not be pre-emptive enough to check the aggressive tax-drivenn leasing transactions, the general anti-avoidance principles define the boundariess of freedom that a taxpayer may reasonably assume in "design-ing"" the legal form of leasing transactions. The general anti-avoidance prin-cipless emerging from various court decisions could be encapsulated as follows: :

5.2.2.1.. The Ramsay principle (W.T. Ramsay v. IRQ196

InIn the landmark case of W. T. Ramsay v. IRC, the House of Lords estab-lishedd the principle that a court is not compelled to look at a document or a transactionn in isolation, divorced from the context to which it properly be-longs.. If a document or transaction was intended by the parties to it to have aa particular effect as part or nexus of a series of transactions, or as an ele-mentt in a wider transaction intended by the taxpayer to operate as a whole, thenn the court is not obliged to view the document or the transaction in ac-cordancee with the purported legal effect; and the court is free to consider thee transaction in accordance with the intended effect. This principle is now commonlyy referred to as the Ramsay principle.

194.. See observations of the Supreme Court in FrankLyon Co. v. United States, 435 U.S. 561;; Sun Oil Co. v. Commissioner, 562 F.2d 258 (3rd Cir. 1977), cert. Denied, 436 U.S. 9444 (1978); Emershaw v. Commissioner, 59 T.CM. (CCH) 621 (1990), affd, 917 F.2d 10400 (8th Cir. 1990); Levy v. Commissioner, 91 T.C. 838 (1988).

195.. See Ballard, Richard, and Davison, Paul, "Form and Substance in Tax Law" (Chap-terr for the United Kingdom), Cahiers de droit fiscal international, Volume LXXXVIIa, IFAA 2002 Congress, Oslo.

Inn Ramsay, the House of Lords also emphasized that the tax authorities and thee courts are not obliged to take a piecemeal approach towards the compo-nentt steps forming part of a composite transaction.197

5.2.2.2.. The step-transaction doctrine (Furniss v. Dawsonm and

CravenCraven v. White199)

InIn Furniss v. Dawson, the House of Lords fine-tuned the Ramsay principle andd held that in case of a preordained series of transactions intended to op-eratee as such, the fiscal consequences must be ascertained by considering thee aggregate result of the series as a whole, and not by dissecting the schemee and considering each individual transaction separately.200

Inn Craven v. White, the House of Lords explained that a court must deter-minee the tax consequences of a series of transactions in a three-step manner, ass follows:

(i)) first, a court must construe the relevant statute in order to ascertain its meaning; ;

(ii)) next, it must analyse the series of transactions in question, regarded as aa whole, so as to ascertain its true legal effect; and

(iii)) finally, it must apply the statute as construed in accordance with the truee legal effect of the series of transactions.

5.2.2.3.. Trading transactions v. transactions with the sole objective of obtainingg tax advantage (Overseas Containers (Finance)

Ltd.Ltd. v. Stoker (Inspector)20* and Lupton v. FA. &AB. Ltd.202)

Inn Overseas Containers (Finance) Ltd. v. Stoker (Inspector), the Court of Appealss held that a transaction can be regarded as a trading transaction only

197.. For a discussion on the Ramsay principle, also see Ballard, Richard, and Davison, Paul,, "Form and Substance in Tax Law" (Chapter for the United Kingdom, paragraph 2.2),, Cahiers de droit fiscal international, Volume LXXXVIIa, IFA 2002 Congress, Os-lo. .

198.. (1984) 1 All ER 530. 199.. (1988) 3 All ER 495 (HL).

200.. For a discussion on Furniss v. Dawson and Craven v. White, also see Ballard, Ri-chard,, and Davison, Paul, "Form and Substance in Tax Law" (Chapter for the United Kingdom),, Cahiers de droit fiscal international, Volume LXXXVIIa, IFA 2002 Con-gress,, Oslo.

201.. (1991) 188 ITR 383 (CA). 202.. [1972] AC 634 (HL).

Relevantt anti-avoidance rules in select Jurisdictions: a brief overview

iff it embodies an underlying commercial purpose; and once a transaction is foundd to be a trading transaction, the existence of a collateral objective of obtainingg a tax advantage would not denature it. However, if the facts dem-onstratee that the sole purpose behind a transaction was to derive a tax ad-vantage,, then as a matter of law, it could not be regarded as having been undertakenn for a commercial purpose and hence could not be treated as a tradingg transaction.

LuptonLupton v. FA. & AJS. Ltd. involved a dividend-stripping transaction (by a

sharee dealer), devoid of any commercial purpose, undertaken for the sole objectt of deriving a tax advantage. The House of Lords was required to de-cidee whether such a transaction could be regarded as a trading transaction. Thee House of Lords unanimously held that since the transaction was carried outt for the sole purpose of deriving a tax advantage, it could not be regarded ass a transaction within the scope of a normal trade of share dealing. In this context,, the following extract from the speech delivered by Lord Morris of Borth-y-Gestt lays down an important principle:

Itt is manifest that some transactions may be so affected or inspired by fiscal considerationss that the shape and character of the transaction is no longer that off a trading transaction. The result will be, not that a trading transaction with unusuall features is revealed, but that there is an arrangement or scheme which cannott fairly be regarded as being a transaction in the trade of dealing in shares. Itt is relevant to also note that in the same decision, referring to the speech off Lord Morris of Borth-y-Gest in Griffiths v. JJ>. Harrison (Watford)

Ltd,Ltd,203203 Viscount Dilhorne reiterated that a trading transaction does not cease too be such merely because it is undertaken by the taxpayer with the expect-ationn of a fiscal advantage; if a transaction is established to be a trading transaction,, it does not lose its character as a consequence of the fiscal ad-vantage. .

5.2.2.4.. The limits of the Ramsay principle (MacNiven (Inspector of

Taxes)Taxes) v. Westmoreland Investments Ltd204)

WestmorelandWestmoreland is one of the crucial decisions concerning the issue of tax

avoidancee in the United Kingdom, as it stipulates a new angle narrowing

203.. [1963] A.C.I.

downn the Ramsay principle.205 In this decision, Lord Hoffmann, while ex-plainingg the Ramsay principle, stressed that:

-- in Ramsay, Lord Wilberforce was interpreting the words "disposal" andd "loss" as commercial concepts. Since the said concepts were not necessarilyy confined to the categories of legalistic analysis, and since analysingg the transaction in a strict legalistic fashion (and thereby treat-ingg each step in the transaction as autonomous and independent) would nott have been determinative, he was applying the commercial mean-ingss to the said statutory words; accordingly, Lord Wilberforce was contrastingg between legalistic or arithmetical realities on the one hand andd commercial realities on the other;

-- it is necessary to construe the statutory language and ascertain whether itt refers to a concept that Parliament intended to be given a commercial meaningg capable of transcending the juristic individuality of its com-ponentt parts. However, there are many terms in tax legislation that can-nott be construed in this manner. Such terms refer to purely legal conceptss that have no broader commercial meaning. In such cases, the Ramsayy principle would have no application, and it would be irrelevant whetherr or not the transaction was undertaken with a business purpose; -- even if a statutory expression refers to a business or economic concept, onee cannot disregard a transaction that comes within the statutory lan-guage,, construed in the correct commercial sense, simply on the groundd that it was entered into solely for tax reasons.

Itt is also important to note the following observation by Lord Hutton in his speech: :

II consider that an essential element of a transaction to which the Ramsay prin-ciplee is applicable is that it should be artificial. The requirement that there must bee artificiality and the importance of distinguishing between the real world and thee world of make-belief, between a real gain (or loss) and a contrived and un-realisticc gain (or loss) have been stressed in a number of judgments of the Housee where the application of the Ramsay principle has been considered.

205.. For a discussion on this case, also see Ballard, Richard, and Davison, Paul, "Form andd Substance in Tax Law" (Chapter for the United Kingdom, paragraph 3.1), Cahiers

Relevantt anti-avoidance rules in select jurisdictions: a brief overview

5.2.3.. Germany and the Netherlands

Inn Germany, Sec. 42 of the General Tax Law (Abgabenordnung, AO) con-tainss the general anti-avoidance rule. However, Sec. 42 AO is not applic-ableable in the case of transactions that have at least some economic substance, evenn if such transactions are tax advantaged.206

Inn the Netherlands, Art. 31 of the General Taxes Act contains the general anti-avoidancee provision (richtige heffing), which may be applied only with thee authorization of the State Secretary of Finance. However, since 1 Au-gustt 1987, no such authorization has been granted, and rather than resorting too the said Art. 31, tax avoidance is countered by resorting to the fraus legis principlee developed by the Supreme Court.207

Thee principle of fraus legis may be applicable in situations where a tax-payerr undertakes a transaction exclusively or predominantly with the ob-jectivee of obtaining a tax advantage that is in conflict with the legislative

intent.. In other words, for the principle of fraus legis to apply, the trans-actionn must cumulatively satisfy the following two prerequisites:208 (i)) existence of motive to reduce tax; and

(ii)) a conflict between the tax consequences of the transaction and the le-gislativee intent.

Inn situations where fraus legis is applicable, a transaction may be recharac-terizedd with a view to apply the tax treatment in accordance with the legis-lativee intent and the economic substance of the transaction.

Thee principle of fraus legis does not apply to transactions in which the tax-payerr primarily has a commercial motive. Accordingly, respectability of a transactionn hinges on the taxpayer's ability to demonstrate the commercial motivee or economic substance, primary importance, underlying the trans-action. .

206.. See International Bureau of Fiscal Documentation, Guides to European Taxation,

EuropeanEuropean Taxation Database (German Chapter, paragraph 13.1.).

207.. For a discussion on this case, also see IJzerman, Robert, "Form and Substance in Taxx Law (Chapter for the Netherlands, paragraph 3.1), Cahiers de droit fiscal

interna-tional,tional, Volume LXXXVIIa, IFA 2002 Congress, Oslo.

208.. On application of the fraus legis principle under the Dutch tax law, see IJzerman, Robert,, "Form and Substance in Tax Law" (Chapter for the Netherlands, paragraph 4.1),

53.. Legal systems: impact on tax-driven cross-border

leasingg transactions

Beforee dealing with the specific types of tax-driven leasing transactions, we mayy briefly consider the impact that a legal system may have on tax-driven cross-borderr leasing transactions. For this purpose, a legal system is viewed,, in a rather limited context, in respect of the approach followed in a jurisdictionn for application of the provisions of a tax law to a given transac-tion.. In this respect, a legal system may be either more inclined towards "formall reasoning" or towards "substantive reasoning". For brevity, a legal systemm that is more inclined towards formal reasoning is hereafter referred ass "formalistic legal system", and a legal system that is more inclined to-wardss substantive reasoning is referred as "substantive legal system". Inn a formalistic legal system, a transaction would have tax consequences in accordancee with its legal form (rather than its economic substance), unless suchh a result is negated by the general or specific anti-avoidance rules. The Unitedd Kingdom could be cited as an example of such legal system. On the otherr hand, in a substantive legal system, the tax consequences of a trans-actionn are likely to be determined on the basis of the economic substance (ratherr than the legal form) of the transaction. The United States, Germany andd the Netherlands could be cited as examples of substantive legal sys-tems. .

Thee differing tax impact due to dissimilarities in the two types of legal sys-temm could be illustrated by considering a hypothetical finance lease trans-action.. In the case of a formalistic legal system, a finance lease would be respectedd as a lease transaction on the basis of the contract's legal effects (i.e.. the legal ownership in the leased asset continuing to vest with the les-sor).. Accordingly, in such a legal system, the lessor would be eligible to claimm tax depreciation in respect of the leased asset, and the lessee would bee eligible to claim the revenue deductions in respect of the lease rentals. Onn the other hand, in a substantive legal system, a finance lease transaction mayy be recharacterized as a transaction for sale and purchase of the asset, soo that the lessor would not be eligible to claim tax depreciation in respect off the leased asset, as he would not be regarded as the "real" owner of the asset.. But, as a corollary, in this kind of legal system, only the finance in-comee component out of the gross lease rentals would be liable for taxation, unlikee the gross lease rentals being liable to tax in a formalistic legal sys-tem. .

Legall systems: impact on tax-driven cross-border leasing transactions

Itt is submitted that a leasing transaction is granted a rather rigid tax treat-mentt in a formalistic legal system as compared to a substantive legal sys-tem.. While it may be possible to argue that a formalistic legal system affordss a greater degree of certainty as regards the tax treatment of lease transactions,, it is also arguable that in such legal system, a taxpayer may be inn an advantageous position to manoeuvre the transaction to his benefit by mouldingg the transaction into a legal form that would yield the desired tax consequences,, as long as the transaction is not negated by a specific anti-avoidancee provision or general anti-avoidance principles.209 For that rea-son,, it is submitted that a taxpayer operating in a formalistic legal system mayy more often (as compared to a taxpayer operating in a substantive legal system)) be in a position to obtain tax consequences that may be inconsistent withh the true economic substance of the transaction. On the other hand, in aa substantive legal system, at least in a domestic leasing situation, it may be comparativelyy difficult (though not always impossible) for a taxpayer to se-curee a tax consequence different from the transaction's true economic sub-stance,, as the mere legal form of the transaction would not be adequate to steerr the tax consequences to his benefit. Accordingly it is submitted that, att least in respect of the tax-driven leasing transactions based on exploita-tionn of the transaction characterization rules of a tax law (e.g. sale-and-leasebackk transactions), a formalistic legal system is more susceptible to "abuse"2100 as compared to a substantive legal culture. For that reason, it is alsoo submitted that the tax authorities and courts inn a formalistic legal sys-temm are far more dependent on the anti-avoidance rules (general as well as specific)) to counter the aggressively tax-driven leasing transactions as com-paredd to their counterparts in a substantive legal system.211 It is further sub-mittedd that since the specific anti-avoidance provisions may not be

pre-209.. For instance, a lessor could secure tax depreciation by retaining the legal ownership inn the leased asset with him.

210.. Here, die word "abuse" is not used in a technical sense since, from a strict legalistic pointt of view, a transaction that is not negated by a anti-avoidance rules may not be re-gardedd as abusive.

211.. For clarity, it may be appropriate to note that this proposition does not imply that mee tax authorities and courts in the substantive legal system would never be required to resortt to the anti-avoidance rules. It is discernible that even in a substantive legal system, itt may be possible for some taxpayers to undertake certain aggressively tax-driven trans-actionss (e.g. like-kind exchange structures discussed later in this chapter) in a manner thatt may escape the substantive attributes of a tax system, unless negated by specific anti-avoidancee provisions. However, it would be appropriate to stress that in a formalis-ticc legal system, taxpayers appear to have greater possibilities of effectively carrying out aggressivelyy tax-driven leasing transactions compared to their counterparts operating in aa substantive legal system, since the legal form (rather than the economic substance) wouldd play a greater role in determining the tax consequences in a formalistic legal sys-tem. .

emptivee enough to check an aggressive tax-driven leasing transaction, for counteringg "innovative" transactions, the tax authorities and courts would bee compelled to rely heavily on the general anti-avoidance principles as comparedd to the specific anti-avoidance provisions in a tax law.212 But, ironically,, it may be often possible for a taxpayer to successfully shield the transactionn against the general anti-avoidance principles by suitably infus-ingg a commercial or economic reason into the transaction, since normally, ass discussed in 5.2., the general anti-avoidance principles do not disturb a transactionn embodying a valid economic substance or commercial reason. Unlikee a domestic lease transaction that is influenced by a single legal sys-tem,, a cross-border leasing transaction is influenced by two or more legal systemss on account of the cross-border element in the transaction. Accord-ingly,, the influence of legal systems on cross-border leasing transactions couldd be more complex as compared to the domestic lease transactions; and att the same time the parties to the transactions may have greater possibili-tiess of deriving tax benefits from a tax-driven lease. In a cross-border lease wheree one jurisdictions adopts formalistic legal system and the other juris-dictionn adopts substantive legal system, it may be possible for the lessor andd the lessee to suitably formulate the transaction to exploit the features of bothh the system to their advantage. A double-dip lease could be regarded as aa classic example in this respect, where the lease is designed in such a man-nerr that both the lessor and the lessee would be regarded owners of the leasedd asset in their respective legal systems.

Itt is relevant to note that for the taxpayers to be able to exploit the differ-encess between the two legal systems, it is not necessary that one legal sys-temm be formalistic and the other legal system substantive. It may be possiblee for the taxpayers to derive an advantage even where both the legal systemss are substantive, but due to the differences in the criteria for attrib-utingg the economic ownership, the lessee and the lessor both may be re-gardedd as owning the leased asset in their respective jurisdictions. However,, it is submitted that where both the legal systems are formalistic, itt would not be possible for the lessor and the lessee to simultaneously

de-212.. It could be argued that once a particular type of aggressively tax-driven leasing transactionn is squarely covered by a specific anti-avoidance provision, it ceases to exist ass an "insoluble" problem for the tax authorities. Also, if a particular type of leasing transactionn is negated by a specific anti-avoidance provision of the relevant tax law, the legall system (whether formalistic or substantive) would not make a difference since the transactionn would be in any case governed by the specific provision irrespective of the jurisdictionn following the formalistic or substantive legal system.

Tax-drivenn leasing transaction structures

riverive such an advantage since only one of the two parties (generally the les-sor)) would be regarded as the legal owner of the leased asset.

55 A. Tax-driven leasing transaction structures

5.4.1.. Sale and leaseback

5.4.1.1.. Nature of the transaction

Salee and leaseback is one of the primitive leasing techniques whereby the ownerr of an asset sells the asset, and the buyer leases back the same to the erstwhilee owner. A sale-and-leaseback transaction may have been entered intoo (from the perspective of the original owner/lessee of the asset) either forr commercial reasons, or for the sole purpose of obtaining a tax advan-tage.2133 It is submitted that, just as a lease transaction per se does not amountt to an abusive transaction, not every sale-and-leaseback transaction shouldd be viewed as an abusive transaction. For instance, an enterprise may enterr into a sale-and-leaseback transaction to augment its working capital byy relieving investment in fixed assets. Such a transaction may be entered intoo by the original owner/lessee of the asset for sound business reasons, thoughh it may also give rise to a tax advantage.

Itt is possible that a sale-and-leaseback transaction may involve change of onlyy legal ownership, while the economic ownership of the asset may vest inn the same person (the original owner/lessee) prior to as well as subsequent too the transaction. It is submitted that the tax-motivated sale-and-leaseback transactionss can be more effectively resorted to in the formalistic legal sys-temss granting depreciation allowance on the basis of mere legal ownership off the asset, as compared to the substantive legal systems requiring eco-nomicc ownership for eligibility of tax depreciation in respect of an asset, sincee generally the original owner/lessee would continue to retain the eco-nomicc ownership over the leased asset. As a result, it appears that a tax sys-temm allowing depreciation on the basis of the economic ownership (rather thann the legal ownership) possesses an inherent check against the tax-mo-tivatedd sale-and-leaseback transactions. That seems to be the reason why specificc anti-avoidance provisions to counter certain types of sale-and-leasebackk transactions are found in the tax laws in the countries (for

in-213.. As regards tax-motivated sale-and-leaseback transactions, see Cozart, Toby, "Dis-putingg U.S. IRS Rev. Rul. 99-14: Pre-tax Profit, Defeasance and Circular Leases", Tax

stance,, the United Kingdom and India) granting depreciation allowance on thee basis of legal ownership, while they are not found in the tax laws of otherr countries (e.g. the United States and the Netherlands) that grant de-preciationn allowance on the basis of economic ownership in the asset. 5.4.1.2.. The US: Court of Appeals decision in Sun Oil Co. v.

CommissionerCommissioner of Internal Revenue214

Inn this case, the taxpayer entered into an agreement with a tax-exempt trust forr sale of a large number of service stations owned by the taxpayer. At the samee time, the taxpayer entered into a leaseback agreement with a primary leasee term of 25 years with an option to renew the lease by a further 65 years.. Based on the terms of the arrangement between the taxpayer and the tax-exemptt trust, the Court of Appeals ruled that the transaction was in the naturee of a financing arrangement rather than a lease. However, it is rele-vantt to note that the tax authorities challenged the transaction on the basis off characterization principles rather than any anti-avoidance provision, and thee Court reached its conclusion on the same basis.215 This supports the view,, expressed at 5.3., that a tax system allowing depreciation on the basis off the economic ownership (rather than the legal ownership) possesses an inherentt check against the tax-motivated sale-and-leaseback transactions.

5.4.1.3.. United Kingdom

5.4.1.3.1.. Restrictive provision under the Capital Allowances Act 2001 Salee and finance leaseback was one of the common forms of lease transac-tionss observed in the United Kingdom in the past. However, the tax advan-tagess of sale-and-finance-leaseback transactions are now reduced due to introductionn of the capital allowance restrictions discussed below.

214.5622 F.2d 258 (US Court of Appeals for the third circuit).

215.. Also see: "Notes & Comment - Hilton v. Commissioner: Tax Court Sharpens Sale-Leasebackk Analysis", Virginia Tax Review Fall 1981.

Tax-drivenn leasing transaction structures

Withh effect from 2 July 1997, in the case of sale and finance leaseback of plantt or machinery, the acquisition value for the seller is restricted to the lowerr of the following:216

-- the amount of capital expenditure on plant or machinery originally in-curredd by the seller;

-- sale price of plant or machinery, -- market value of plant or machinery; and

-- the notional written-down value incurred by the seller or a person con-nectedd with the seller.217

Itt is relevant to note that this restriction does not altogether eliminate the capitall allowance entitlement of the lessor, but only casts a limitation on suchh an entitlement. Also, the above-stated provision applies only to cases off sale and finance leaseback, but not to sale and operating leaseback. For thee purposes of this restriction, a lease is regarded as "finance lease" if it amountss to finance lease under the accounting principles. According to SSAPP 21, where a lease transaction has the effect of a substantial transfer off the risks and rewards of ownership in the leased asset from the lessor to thee lessee, the transaction is regarded as a "finance lease". Risks and re-wardss are regarded as substantially transferred if at the inception of a lease thee present value of the minimum lease payments, including any initial pay-ment,, constitutes a substantial portion (at least 90% or more) of the fair val-uee of the leased asset.218 Thus, a sale-and-leaseback transaction under whichh the seller/lessee commits to pay to the lessor up to 89.99% of the fair valuee of the asset in the form of lease rentals and initial payment does not amountt to finance lease; and in such cases the above-mentioned restriction wouldd not apply. Depending on the nature of the asset, there could be cases wheree the lessor could reasonably expect to more than recoup the differ-encee between the fair value of the asset at the inception of the lease and the paymentss receivable from the lessee, by selling the asset at the end of the

216.. Capital Allowances Act 2001, Sec. 224. See, also, discussion at 3.5.2.6. and Price-waterhouseCoopers,, Leasing in the UK (4th Edition) (Tolley LexisNexis), paragraphs 22.179-22.190;; and Sherry, Michael, and Rippon, Louise, Whiteman on Income Tax (14thh Cumulative supplement to the 3rd edition) (Thomson Sweet & Maxwell), Chapter Al,, paragraph A1B-114 to A1B-116.

217.. For this purpose, the "notional written-down value" means the tax written-down valuee that would have been attributable to the plant or machinery, as if it was in a sep-aratee pool and as if the maximum available amount of capital allowance was claimed in eachh accounting period subsequent to the acquisition of the plant or machinery. The amountt of notional written-down value is independent of whether or not the owner of the assett was entitled to claim capital allowances, and whether or not he had claimed such capitall allowances.

leasee term. Thus, the above-mentioned restriction may not always frustrate aa sale-and-leaseback transaction.

Ass per another restrictive provision under the UK Capital Allowances Act 2001,, capital allowances are altogether denied to the lessor in the case of a salee and finance leaseback of plant or machinery, if as a part of the lease arrangementt more than 50% of the risk of non-compliance by the lessee is removedd (for instance, removal of such risk by way of a defeasance ar-rangementt or a bank guarantee).2'9

5.4.1.3.2.. UK Court of Appeals decision in BMBF case

Itt is relevant to note that recently, in Barclays Mercantile Business Finance

Ltd.Ltd. v. Maw son (Inspector of Taxes),220 the Court of Appeals respected a sale-and-leasebackk transaction. The said case is discussed at 5.4.13.2.

5,4.1.4.. Netherlands: "technolease" cases

Thoughh tax law in the Netherlands does not contain anti-avoidance provi-sionss to counter sale-and-leaseback transactions, it is relevant to take note off two "technolease" transactions involving the sale and leaseback of intan-giblee properties. Although leasing of intangible properties is beyond the scopee of this study, as the issue involved in the "technolease" transactions iss also relevant for leasing of tangible assets, the same is briefly pointed out here. .

InIn one of the "technolease" transactions, a leading Dutch multinational companyy ("the company") sold its know-how to a Dutch bank for about NLGG 2.8 billion, of which the bank immediately paid NLG 600 million to thee company. At the same time, the bank leased back the know-how to the companyy for a period often years to ensure that the company could contin-uee using the know-how for its business purposes. As a consideration for the leaseback,, the company agreed to pay to the bank an annual royalty of NLG 1400 million and share with the bank 50% of the proceeds from licences basedd on the know-how. In another "technolease" transaction, a Dutch air-craftt manufacturer sold its patent rights in respect of core technologies to a bankk and leased them back.

219.. See discussion at 3.5.2.7. 220.. [2003] STC 66.

Tax-drivenn leasing transaction structures

Onn 26 August 1994, the Dutch State Secretary of Finance issued a decree clarifyingg that for obtaining a tax benefit from a sale-and-leaseback trans-action,, the lessor must be the economic owner of the asset. The intent un-derlyingg the said decree could be viewed as to frustrate transactions similar too the above-mentioned "technolease" cases, since companies are expected too be averse to parting with the economic ownership of critical intangible assetss such as core technologies. However, it is submitted that since, in any case,, Dutch tax law provides for depreciation on the basis of economic ownershipp of the asset, the said decree may be regarded as providing mere clarificationn rather than providing an anti-avoidance measure to counter sale-and-leasebackk transactions. Even in the absence of the decree, the les-sorr could qualify for tax benefits only if he was the economic owner of the asset,, which once again demonstrates the proposition advanced in 5.3. that, ass compared to a formalistic legal system, it is difficult for a taxpayer op-eratingg in a substantive legal system to derive a tax advantage from a leas-ingg transaction by virtue of mere legal form of the transaction.

5.4.2.. Chain-lease structure

5.4.2.1.. Nature of the transaction

Itt appears that with a view to circumvent the UK capital allowance restric-tionss in respect of overseas leasing, some finance lessors have attempted chain-leasee transactions. A chain-lease transaction may typically involve a long-termm lease (headlease) to a UK resident sublessor and medium-term (lesss than 13 years) sublease to non-resident end user lessees. Recently, one suchh transaction was examined by the Chancery Division of the High Court inn BMBF (No. 24) Ltd v. Inland Revenue Commissioners.211

5.4.2.2.. BMBF (No. 24) v. Inland Revenue Commissioners

5.422.1.5.422.1. Relevant facts

Inn this case, Caterpillar Inc. ("CI"), a large US manufacturer of earth-mov-ing,, mining, construction and agricultural equipment, sought to raise

nancee by exploiting the UK capital allowance222 regime.223 For this purpose, CII undertook a sale-and-leaseback transaction (through its wholly owned UK-basedd subsidiary). The relevant facts about the transaction were as fol-lows: :

-- On 14 December 1995, CI sold certain equipment situated and used in itss factories in the United States to its wholly owned subsidiary called Caterpillarr International Leasing LLC ("CIL"), which was a resident in thee United Kingdom.224 The said equipment was capable of being re-movedd from the factories of CI.

-- On 18 December 1995, BMBF (No. 24) (a UK company, hereinafter referredd as "the lessor") agreed to purchase the said equipment from CILL for GBP 165 million, and it paid the said purchase price.

-- On 18 December 1995, the lessor leased back (hereinafter referred as "headlease")) the equipment to CIL for a term of 30 years and 19 days. Thee headlease was a standard finance lease, with provisions for rentals escalatingg throughout the duration of the lease term.

-- Also on 18 December 1995, with the consent of the lessor, CIL sub-leasedd the equipment to CI for 11 years. The sublease was a standard operatingg lease with rentals evenly spread out over the lease term. -- Also on 18 December 1995, the lessor stated in a letter to CIL that CIL

couldd enter into further subleases (beyond the original sublease for 11 years)) with the prior written consent of the lessor, and the lessor af-firmedd in the said letter that such consent would not be unreasonably withheldd if certain specified conditions were satisfied. One such condi-tionn was that the further sublease (beyond the original 11-year sub-lease)) must not prejudice the lessor's right to claim the capital allowances. .

222.. Referred to as "Written Down Allowances" (WDA) in the decision.

223.. Etherton J. noted in his judgement that the structure of the transaction, involving salee and leaseback of the equipment and the (anticipated) availability of capital allow-ancess was designed, inter alia, to provide CI with cheaper finance than, for example, an ordinaryy loan.

224.. CIL was incorporated in Delaware on 31 October 1995 as a limited liability com-pany.. It registered in the United Kingdom as an overseas company, and was resident in thee United Kingdom for tax purposes.

Tax-drivenn leasing transaction structures

5.4.2.2.2.. Relevant statutory provisions

Sec.. 42 of the then applicable Capital Allowances Act 1990 reduced the capitall allowance entitlement of a lessor to 10% (instead of the ordinary ratee of 25%) in the case of machinery or plant that was used for the purpose off being leased to a person not resident in the United Kingdom. The capital allowancee entitlement was altogether denied in the cases to which Sec. 42(3)) applied. As the entire decision (running into over 80 pages) is based onn interpretation of the language of the said Sec. 42, it is essential to repro-ducee Sec. 42 as starting point of the analysis.

Sec.. 42 of the Capital Allowances Act 1990 provided as follows: Assetss leased outside the United Kingdom

(1)) This section has effect with respect to expenditure on the provision of ma-chineryy or plant for leasing where the machinery or plant is at any time in the requisitee period used for the purpose of being leased to a person who -(a)) is not resident in the United Kingdom, and

(b)) does not use the machinery or plant exclusively for earning such profits or gainss as are chargeable to taxx (whether as profits or gains arising from a tradee carried on in the United Kingdom or by virtue of section 830(4) of thee principal Act,

andd where the leasing is neither short-term leasing nor the leasing of a ship, air-craftt or transport container which is used for a qualifying purpose by virtue of sectionn 39(6) to (9).

(2)) In their application to expenditure falling within subsection (1) above, sec-tionss 24,25 and 26 ... shall have effect, subject to subsection (3) below, as if thee reference in section 24(2) 25 per cent were a reference to 10 per cent. (3)) No balancing allowances or writing-down allowances shall be available in respectt of expenditure falling within subsection (1) above if the circumstances aree such that the machinery or plant in question is used otherwise than for a qualifyingg purpose and

-(a)) there is a period of more than one year between the dates on which any twoo consecutive payments become due under the lease; or

(b)) any payments other than periodical payments are due under the lease or underr any agreement which might reasonably be construed as being col-laterall to the lease; or

(c)) disregarding variation made under the terms of the lease which are attributablee to

-(i)) changes in the rate of corporation tax or income tax; or (ii)) changes in the rate of capital allowances; or

(iii)) changes in any rate of interest where the changes are linked to chang-ess in the rate of interest applicable to inter-bank loans; or

(iv)) changes in the premiums charged for insurance of any description by aa person who is not connected with the lessor or the lessee, anyy of the payments due under the lease or under any such agreement as iss referred to in paragraph (b) above, expressed as monthly amounts over thee period for which that payment is due, is not the same as any other such paymentt expressed in the same way; or

(d)) either the lease is expressed to be for a period which exceeds 13 years or theree is, in the lease or in a separate agreement, provision for extending or renewingg the lease or for the grant of a new lease so that, by virtue of that provision,, the machinery or plant could be leased for a period which ex-ceedss 13 years; or

(e)) at any time the lessor or a person connected with him will, or may in cer-tainn circumstances, become entitled to receive from the lessee or any other personn a payment, other than a payment of insurance money, which is of ann amount determined before the expiry of the lease and which is referable too a value of the machinery or plant at or after that expiry (whether or not thee payment relates to a disposal of the machinery or plant).

5.422.3.5.422.3. Relevant issues before the High Court

Thee following issue dealt with by the High Court is relevant for the purpose off this research:

Whetherr the "lease" referred to in Sec. 42(3) is the headlease or the sub-lease.2255 If such lease was the sublease, then Sec. 42(3) would not affect the lessor'ss entitlement to capital allowance as the sublease did not possess any featuress referred to in Sec. 42(3)(a) to (e). Conversely, if Sec. 42(3) applied too the headlease, then the lessor would not be entitled to capital allowance onn the leased equipment, as the headlease contained the conditions (e.g. leasee term exceeding 13 years) referred to in Sec. 42(a) to (e).

5.4.2.2.4.. Decision by the High Court on applicability of Sec. 42(3) to

headleaseheadlease or sublease

Thee lessor argued before the High Court that the lease referred to in Sec. 42(3)) was the lease to the non-resident specified in Sec. 42(1), i.e. the sub-225.. It is relevant to note that in the presently applicable Capital Allowances Act 2001, ass per Sec. 105(l)(b), a reference to a lease includes a sublease. As a result, it is submit-tedd that this issue involving interpretation of the relevant provisions of the Capital Al-lowancess Act 1990, would no longer arise under the Capital Allowances Act 2001.

Tax-drivenn leasing transaction structures

leasee in the instant case. On the other hand, the Revenue contended that oncee the asset was used for the purpose of providing a lease to a non-resi-dentt specified in Sec. 42(1), Sec. 42(3) applied to the lease to the owner of thee asset, i.e. the headlease, irrespective of whether the lessee under the headleasee was a non-resident.

Ass a starting point for analysing the issue, the Court looked at the legisla-tivee purpose underlying Sec. 42(3). The Court noted that the normal 25% ratee of capital allowance was considerably in excess of commercial rates of depreciationn of machinery or plant, and any unused capital allowance could bee surrendered to other members of the group of which the trade of the les-sorr formed a part. The Court further stated that if, in the case of a finance lease,, all the parties226 were resident in the United Kingdom, then the mis-matchh between the generous 25% rate of capital allowances and the lower ratee of commercial depreciation and rentals would not be of any great prac-ticall significance in terms of tax collection, as any commercial advantage onn account of low rentals227 would result in higher profits taxable in the Unitedd Kingdom.

Thee counsel for the lessor argued that the purpose of Sec. 42 was to target leasess to non-residents. In support of the said argument, the counsel sought too rely on the following statement by the finance minister, made in the com-mitteee in the House of Commons in relation to the then proposed draft clausee for reduction of capital allowances from 25% to 10% where the ma-chineryy or plant is used for the purpose of being leased to a non-resident:

II have already told the Committee why changes are needed in the capital allow-ancess for assets leased abroad and the thinking behind the 10 per cent., but theree is one aspect of the new arrangements that we shall want to come back to onn Report if they are to be effective preventing further exploitation of capital

allowancesallowances for the benefit of firms abroad. The 10 per cent allowance broadly

allowss the lessor to write off his capital outlay over a period of 14 or 15 years. Inn the normal case this is a reasonable provision without being unduly generous att the taxpayer's expense, but it is already clear that schemes are being de-velopedd to arrange the terms of foreign leases in such a way that they continue too incorporate a significant element of tax subsidy. Those schemes appear to relyy on artificially skewing the profile of the rental payments by, for example, rear-endd loading the capital repayments or by contriving very long leases. In eachh case the result is the same. The 10 per cent allowance would still be over-226.. I.e. the finance lessor, the finance lessee and any sublessee.

227.. Low rentals, as the lessor would pass on the benefit of capital allowance to the les-seee by way of a reduction from the lease rentals.

generous.. Those devices are being openly discussed. If we took no action they couldd frustrate the intention behind the clause in a significant number of cases. Wee do not mean to let that happen. We are therefore giving thought to how best too deal with this matter, but it has not been possible in the time available to pparee firm proposals to put before the committee. We shall therefore wish to re-turnn to the subject on Report and we shall ask the House to provide that the amendmentt that we shall propose on Report should be effective from today. However,, the Court rejected the argument of the lessor's counsel.

Inn the Court's view, the purpose of Sec. 42 of the Capital Allowances Act 19900 was to curtail the commercial and tax advantages conferred by the or-dinaryy 25% rate of capital allowances, where the plant or machinery was leasedd to a non-resident; that curtailment was intended to be achieved by matchingg (a) capital allowances entitlement to the finance lessor, and (b) thee advantage achieved by the finance lessee in the form of lower rentals228 taxablee in the United Kingdom. Thus, in the Court's view, the purpose be-hindd curtailment of the rate of capital allowances was to achieve a neutrality byy netting-off capital allowances and rent, which was possible only if such processs of netting-off was carried out between the finance lessor and the fi-nancee lessee i.e. at the level of the headlease rather than the sublease. Ac-cordingly,, the Court held that Sec. 42(3) applied to the headlease rather thann the sublease. As a consequence, since the headlease was for a term in excesss of 13 years, it was hit by Sec. 43(3)(d), and the lessor was not enti-tledd to any capital allowance in respect of the leased equipment.

Itt is relevant to note that the Court expressed that there were severe defi-cienciess in the drafting of Sec. 42,229 However, in spite of such an acknowl-edgment,, the Court adopted the textual approach of interpretation and analysedd the language of the said section in a hair-splitting manner. For in-stance,, at paragraph 85 it is stated:

II see nothing in the grammar or language of the opening words in Sec. 42(3) too indicate that the phrase "the machinery or plant in question is used otherwise thann for a qualifying purpose" is being used otherwise than to refer to the cur-rentt use of the machinery or plant. Neither grammatically, nor in terms of the

languagelanguage used, is there any obvious indication that the phrase is referring to,

andd only to, use of the machinery or plant under the lease to the non-resident.

228.. Lower rentals on account of capital allowance benefit being passed on by the lessor too the lessee.

Tax-drivenn leasing transaction structures

5.4.2.2.5.. Critical remarks on the High Court decision

Itt is submitted that, contrary to the view expressed by the High Court, the legislativee purpose behind Sec. 42 appears to prevent non-resident lessees fromm deriving a benefit at the expense of the UK exchequer, rather than to achievee a neutrality by netting-off capital allowances and the lease rentals. Iff the legislative purpose behind Sec. 42 was to match a finance lessor's capitall allowance entitlement with taxability of the advantage obtained by thee finance lessee from lower rentals, then capital allowances would have beenn disallowable in the case of all overseas leases, rather than only leases meetingg conditions of Sec. 42(3), since any advantage obtained by the over-seass lessee would not be taxable in the United Kingdom in any case irre-spectivee of the duration of the lease term, or lease rental payments evenly spreadd over the lease term. Also, if the legislative intention was to match thee capital allowance entitlement of the finance lessor with the taxability of thee income of the finance lessee in the United Kingdom, then capital allow-ancess would have been disallowable even in the case of finance leases to tax-exemptt entities resident in the United Kingdom.

5.4.3.. D o u b l e - d i p leasing 5.4.3.1.. Nature of the transaction

Thee International Bureau of Fiscal Documentation, in its International Tax

Glossary,Glossary, defines "double-dip leasing" as:

.... the possibility of obtaining double advantages or benefits in the form of de-preciationn deductions, investment credits, etc. because of differences in various countries'' tax rules on leasing. Typically, a double dip is obtained where the lessorr is resident in a country which regards the lessor as the owner of the leasedd asset, and the lessee is resident in a country which regards the lessee as ownerr if, in substance, the lease transfers the risk and benefits of ownership. In suchh circumstances it may be possible for both the lessor and the lessee to ob-tainn depreciation deductions.230

Ass a typical double-dip transaction is designed to leverage on the differ-encess in the criteria (legal v. economic ownership) for eligibility for tax

de-230.. See, also, Andersson, C. Staf f an, and others, "Cross-border Leasing Provides Major Taxx (and other) Benefits", Tax Notes International 20 March 1991.

preciationn under the tax laws of various countries,231 it appears that a dou-ble-dipp lease transaction is possible only if at least one of the two jurisdic-tion2322 grants depreciation allowance on the basis of economic ownership. Ass stated earlier, a tax-effective double-dip lease transaction may be possi-blee even if both the jurisdictions grant depreciation allowance on the basis off economic ownership of the leased asset and both the lessor as well as the lesseee may be regarded as economic owners of the leased asset in their re-spectivee jurisdiction due to the differences in the criteria for attributing eco-nomicc ownership. In such cases, legal ownership is irrelevant. However, it seemss that a double-dip lease transaction would not be possible where both thee jurisdictions grant depreciation allowance on the basis of legal owner-shipp of the leased asset, as both the lessor and the lessee cannot be simulta-neouslyy regarded legal owners in respect of the same leased asset.

5.4.3.2.. Typical double-dip lease structure

AA typical structure of a double-dip lease transaction may be somewhat like thee following:233

-- A single equity investor or a group of equity investors from a jurisdic-tionn granting depreciation allowance on the basis of legal ownership of thee asset would form a lessor entity (transparent entity in case of group off investors) in the said jurisdiction, so that the equity investor(s) wouldd be subject to a single level of taxation either on the basis of con-solidatedd tax treatment of a group of companies or due to the transpar-entt nature of the lessor entity, as the case may be.234 Similarly, the tax entitlementss (such as the right to set off the tax loss from the leasing transaction)transaction) would flow to the equity investors.

231.. See Rosen, Burt, and others, United States Invokes Substance over Form, Interna-tionall Tax Review Supplement February 1992; and Blau, Denise L., Commercial Law

andand Practice Course Handbook Series, Practising Law Institute October 1995.

232.. I.e. the lessor's jurisdiction and the lessee's jurisdiction.

233.. Also see Blau, Denise L., Commercial Law and Practice Course Handbook Series, Practisingg Law Institute October 1995; Park, William W., "Tax Characterisation of In-ternationall Leases: The Contours of Ownership", Cornell Law Review November 1981; Sheppard,, Lee A., "U.S. Cross-border Tax Arbitrage, 'Hybridity', Mules and Hinnies",

TaxTax Notes International Magazine 23 February 1998; and Todd, Neal, "UK Leasing

De-mandss Skill and Care", International Tax Review April 1997.

234.. In practice, the equity investor(s) could be even from a foreign jurisdiction (i.e. otherr than the residence country of the lessor entity). However,, for simplicity, it is as-sumedd that the equity investor(s) and the lessor entity are from the same jurisdiction.